The Magic of Compounding
The magic of compounding is the main reason it's so important to start saving in your early twenties. People who wait until their forties to start saving will have to save much more than those who started in their twenties. What's worse, they will never be able to catch up with those who started in their twenties without saving and investing drastically higher amounts than would have been necessary had they started at a younger age.
There are two basic methods of calculating interest: simple interest and compound interest. Simple interest is calculated based only on your initial investment. Compounding means that as you earn interest on your investment, it is added to your original investment, and as a result you earn interest on your interest as well. The difference may not seem like much, but the effect that compounding can have over a long period of time is astounding, especially with larger initial investments and higher rates of return.
To illustrate how compounding works, assume you invest $1,000 at 10 percent interest compounded annually. At the end of the first year, you'll have earned $100, for a total of $1,100. At the end of year two, the interest is calculated on $1,100, so you'll earn $110, for a balance of $1,210.
Frequency of Compounding
Interest is usually compounded annually, monthly, or daily. The more frequently compounding takes place, the faster your money will grow. As the balance grows larger, the difference between simple interest and compound interest becomes greater. Let's say you put $5,000 in an account that earns 10 percent interest. Here's what your investment would be worth at the end of ten years if you didn't add another penny to it:
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Compounded annually: $12,968
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Compounded monthly: $13,535
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Compounded daily: $13,589
To illustrate the effect of a longer period of time on compounding, consider Bill, who contributed $2,000 at 6 percent interest to an IRA beginning at the age of twenty-two and continued doing so each year until he was thirty (nine years). By the time he was sixty-five, his $18,000 investment had grown to over $579,000. His friend Jim made a $2,000 contribution every year for thirty-five years, for a total of $70,000, but because he started at the age of thirty-one, his nest egg only totaled $470,000. Even though he contributed much more than Bill ($70,000 versus Bill's $18,000) he ended up with 23 percent less money.
